With Mohamed El-Erian, Chair of President Obama’s Global Development Council, Chief Economic Adviser at Allianz, Author of The Only Game in Town: Central Banks, Instability, And Avoiding The Next Collapse
Mohamed El-Erian addresses the risks posed by exchange traded funds (ETFs), which he views as powerful instruments that deliver diversification and liquidity, but advises investors to remember they are buying the whole basket. It’s like going to a restaurant and ordering the whole menu. When you do this, often the bad components of an ETF can undermine performance from the good ones, and this doesn’t always make sense. Secondly, ETFs give you the delusion of liquidity; because when markets tank, ETFs may trade with prohibitive bid-offer spreads of as much as 10%. He believes ETFs make sense for investments in broad indexes such as the S&P 500 ,but investors need to be cautious when looking at specialized esoteric markets such as high-yield ETFs.
He also talks about the value of gold as a safe haven and believes people romanced gold and took prices too high, but then under-bid to where current gold prices are more reasonable. He recommends having up to 5% gold in your portfolio, because it’s negatively correlated to many other investments and adds diversification.
He believes investors need to be cautious now for two reasons: The Fed’s inability to predict the risks faced by the U.S. economy, and the impact of human behavior when fear precipitates bad investing practices. Finally he addresses how technology is driving exciting innovation while socio-economic winds of change are threatening economic growth.
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Steve Pomeranz: My guest is Mohamed El-Erian, he’s the chief economic advisor at Allianz Informer; CEO and co-chief investment officer at PIMCO. His new book is The Only Game In Town: Central Banks, Instability and Avoiding the Next Collapse, which was just released in January. To hear this interview again, and get more information, don’t forget to join the conversation at OnTheMoneyRadio.org.
Mohamed, in your book you quote the great investor Howard Marks. He was expressing concern, among other things, that the next risk to emerge, we had talked in the last segment about the banks being okay, might be in this area of these index funds, the ETFs. Can you tell us what you think about them, and what you think the risks may be in the future?
Mohamed El-Erian: ETFs are very powerful investment instruments. They allow you to get a diversified exposure to segments of the market, and they give you the impression that you have instantaneous liquidity; because they are priced on high-frequency basis, and are people making markets.
Unlike a mutual fund, you don’t have to wait till the end of the day to sell it, you don’t have to wait till the end of the day to find out how much it’s worth, you can do that during the trading session. There are two elements of an ETF that an investor must never forget. One is you have no choice, you’re buying the whole basket.
It’s a little bit like going into a restaurant and you can’t choose from the menu, you’re going to get the whole menu; so you get some good dishes, but you also get some bad dishes, so you have to be able to digest the bad dishes. Sometimes the bad dishes contaminate the good dishes; so the first thing to realize is that you are buying a whole menu, and that doesn’t always make sense.
For example, today you want to differentiate much more than what an ETF gives you. The second element of an ETF is that it gives you not just the illusion of liquidity, but it turns it into a delusion. As we’ve seen, whenever the market has corrected sharply, if you try to get out, if many people try get out of an ETF at the same time, they will do so at quite a cost; therefore, the liquidity that you think you’re getting is coming at a high cost to you.
Steve Pomeranz: What do you mean, ‘a high cost’?
Mohamed El-Erian: Meaning that you will pay an enormous bid-offer spread; and in some cases, in the more exotic parts of the markets, you may find that that bid-offer spread is prohibitive.
Steve Pomeranz: So if the basket of investments are worth ‘X,’ because of the illiquidity, then you may get ‘X’ minus something, not exactly what it’s worth.
Mohamed El-Erian: Yes, and that minus could be ten percent.
Steve Pomeranz: Oh boy.
Mohamed El-Erian: It’s a meaningful number, and we’ve seen that. Another example of that is one of the mutual funds, Third Avenue, had to shut investor access to their capital; very unusual for a mutual fund. Why? Because they had the same problem that can occur with these more exotic ETFs, the problem of illiquidity.
Steve Pomeranz: Yes.
Mohamed El-Erian: You simply cannot get a market. I think you have to be careful. There are places hydrocodone online usa where ETFs make a lot of sense; if you’re betting on the S & P for example. There are other places where they make a lot less sense. For example, in the high-yield market for corporate debt.
Steve Pomeranz: Yes, so watch out for some of these more esoteric areas that are not quite so liquid and deep. They’re fine when things are fine but when things turn sour, you may find yourself in a bit of trouble.
Mohamed El-Erian: Absolutely correct.
Steve Pomeranz: You know? Everybody is worried about the global economy; I hear this day in and day out. Does gold have any place in these discussions, as a safe haven?
Mohamed El-Erian: It does. It has been an unloved asset because there was excessive romance, previously. Coming out of 2008, people looked at gold and romanced it, and we took the price too far. Now we are at the end of a period of massive adjustment. Gold has gone from being overly loved to being massively under appreciated, and now I think it’s getting back to its place. I think most investors would do well by having gold up to five percent, in their portfolio, as a strategic allocation. Why? Because it is negatively correlated to a number of other things that are very difficult to protect against.
Steve Pomeranz: If you have three percent of gold in your portfolio, is that enough to make a difference?
Mohamed El-Erian: Every percent makes a difference. Think of it as part of diversification. If you have the twenty-five to thirty percent cash that we talked about earlier, and then have on top of that five percent gold, you actually have quite a bit of resilience; and that’s what you need.
Steve Pomeranz: Resilience.
Mohamed El-Erian: I’ll go back to this combination of resilience, resilience and optionality; that is what you want to have as an investor, as the global economy and global markets head to the T junction.
Steve Pomeranz: So capital preservation, right now, you feel is the main goal that people should strive for?
Mohamed El-Erian: For two reasons. First, the world is unusually uncertain; and we are slowly exiting a period of experimentation that we don’t fully comprehend. Certainly the Fed doesn’t fully comprehend. I’ll give you an example. In their latest statement, they refrained from giving their usual guidance on the balance of risks facing the economy; so the most powerful central bank no longer feels in a position to tell us what the balance of risks is for the US economy. That’s a consequential statement, and it’s one that we should hear and internalize. That’s the first reason why.
The second reason has to do with human behavior. When we are not resilient, we end up doing the wrong thing. Investors, in particular, often fall victim to bad behavioral reaction when fear increases
Steve Pomeranz: Mm-hmm, that’s true.
Mohamed El-Erian: So it’s really important to use structure and, in this case, use the ability to have safe assets as a way to limit the risk of making a behavioral mistake.
Steve Pomeranz: You quote Andy Haldane, and this is one of the most wonderful quotes in the book. I’m going to to paraphrase here. He says: “Today the growth picture is foggier. We have fear about economic stagnation, and at the same time we cheer about all of this technological innovation that we’re experiencing. The economic tailwinds from new technology are very strong, but so too are the sociological headwinds. Buffeted by these crosswinds, future growth risks become suspended between the mundane and the miraculous.” I can tell you, Mohamed, that’s exactly how I feel. What is your opinion on that?
Mohamed El-Erian: I love that quote, because it speaks to this T junction; and it’s from someone, Andy, who is at the Bank of England, who is one of the most thoughtful people out there; and it speaks to your reality, my reality. Our world is being shaken from above and from below. We’ve been speaking, so far, about being shaken from above; but we are also being shaken from below. Uber, Airbnb—they are all enabling us to do things that we never thought we could do before. They are empowering individuals in a way that has never done, and they are changing the landscape. Let me give you a simple example. The Hilton Chain: It took him a hundred years to provide seven hundred thousand rooms to their clients. They had to do that by building hotels, by managing hotels. Airbnb, in six years, has been able to provide a million rooms.
Steve Pomeranz: Mm-hmm.
Mohamed El-Erian: A hundred rooms, seven hundred thousand rooms; but you have Airbnb, a million rooms in six years and they haven’t built a single hotel. They are disrupting the world; and enabling us to rent out rooms if we want, to find rooms in a much easier way. I can name one innovation after the other that’s been enabled by this amazing combination of technology, mobility, and the Internet; but every time you enable someone, you also disrupt someone else. That’s why we have this mixture, depending on which side of the equation we’re on. Most of us are actually on both sides of the equation.
Steve Pomeranz: To find out more, and to hear this segment again … And I recommend Mohamed El-Erian’s new book, The Only Game In Town: Central Banks, Instability and Avoiding the Next Collapse. Join the conversation at OnTheMoneyRadio.org. Mohamed, thank you so much for your time. You’ve been very generous and gracious. Once again,thank you.
Mohamed El-Erian: Thank you very much.